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Delays in Climate Transition Can Increase Financial Tail Risks: A Global Lesson from a Study in Mexico

2023-08-25IMFC***

DelaysinClimateTransitionCanIncreaseFinancialTailRisks:AGlobalLessonfromaStudyinMexico DimitriosLaliotisandSujanLamichhane WP/23/175 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2023 AUG ©2023InternationalMonetaryFundWP/23/175 IMFWorkingPaper MonetaryandCapitalMarketsDepartment DelaysinClimateTransitionCanIncreaseFinancialTailRisks:AGlobalLessonfromaStudyinMexicoPreparedbyDimitriosLaliotisandSujanLamichhane AuthorizedfordistributionbyHirokoOuraAugust2023 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:Thispaperexploresanovelforward-lookingapproachtostudythefinancialstabilityimplicationsofclimate-relatedtransitionrisks.Wedevelopanintegratedmicro-macroframeworkwithanewclassofscenariocalleddelayed-uncertainpathways.Anadditionalstochasticfinancialmodelinglayerviaajump-diffusionprocessisconsideredtocapturecontinuouslychangingrisks,aswellasthepotentialoflarge/suddenshocksinthefinancialmarkets.WeappliedthisapproachtostudytransitionrisksintheMexicanfinancialsector.Buttheimplicationsareglobalinscope,andtheframeworkiseasilyadaptabletoothercountries.Wequantifytheprojectionsoffuturedistributionsofvariousriskmetricsand,hence,theevolvingtailrisksduetocompoundingeffectsfromdelaysintransitioningtoalow-carboneconomyandtheconsequentuncertaintyofthefuturepolicypath.Wefindthatthelongerthedelaysintransition,thelargerthefuturetailfinancialrisks,whichcouldbematerialtotheoverallsystem. RECOMMENDEDCITATION:Laliotis,D.andS.Lamichhane.2023.“DelaysinClimateTransitionCanIncreaseFinancialTailRisks:AGlobalLessonfromaStudyinMexico.”IMFWorkingPaperNo.175 JELClassificationNumbers: E44,G12,G21,G32,Q54,Q58 Keywords: Climatechange;transitionrisk;greenhousegasemissions;financialstability;stresstesting;defaultrisk;jump-diffusion Authors’EmailAddresses: DLaliotis@imf.org;SLamichhane@imf.org WORKINGPAPERS DelaysinClimateTransitionCanIncreaseFinancialTailRisks:AGlobalLessonfromaStudyinMexico PreparedbyDimitriosLaliotisandSujanLamichhane Contents I.Introduction5 II.ClimatePolicyrisksinMexico10 III.ModelingFramework12 A.Micro-MacroApproach12 B.TransitionScenariosandStochasticFinancialModel18 IV.ImpactonCorporateandFinancialSectors24 V.Conclusion29 Appendix I.MappingCGEModelSectorstoCorporateSectorsandNAICSSectorClassification30 Introduction1 Climatechangeisalreadygeneratingunprecedentedimpactsaroundtheworldonvarioussegmentsoftheglobaleconomyandhumansociety.TheIntergovernmentalPanelonClimateChange(IPCC),theUnitedNationsbodyforadvancingthescienceonclimatechange,highlightsthattheadverseeconomiceffectsattributabletohuman-inducedclimatechangeareincreasinglybeingobserved,leadingtolarge-scalelossesanddamagestonatureandhumansocietyaroundtheworld(IPCC2022).Physicalhazardsandtheirimpacts—suchasincreasingfrequencyandintensityofextremeclimateevents(forexample,hurricanes,floods,drought,andwildfires)—areprojectedtoincreasefurtherwithglobalwarming.Limitingglobalwarmingrequiressignificanteffortsinandcommitmentstoreducingglobalgreenhousegas(GHG)emissions.Suchactionscouldhaveamaterialeconomicandfinancialimpactonemissions-intensivefirms/sectorsandalsohouseholdsandgovernmentsviadifferentchannels.Thus,transitionrisksariseastheeconomymovestowardalow-carboneconomy,whichcanimpactvarioussegmentsoftheeconomyandthefinancialsector. WorldwideconsensusisbuildingontheneedtointroducestrongerpolicyactionstolimitGHGemissionsandtransitiontoalow-carboneconomy.DuringCOP26,the2021UNclimatesummit,policymakersaroundtheworldmadenewclimatepledgesanddiscussedplanstoreduceemissionstoavertseriousdamagestotheclimatesystem.AtCOP26,morethan120countries,representingabout70percentofglobalemissions,pledgedtobringemissionstonetzerobyaround2050.Andgiventheexposureofthefinancialsystemtotheeffectsofclimatechange,globalregulatorsandcentralbanksincreasinglyrecognizetheneedtoassessandminimizethoseimpactsonfinancialstability. However,despitethewarningsfromtheIPCConrisingglobaltemperatures,moreambitiousanddecisiveactionstolimitGHGemissionsarestillwanting.AccordingtoClimateActionTracker(2022),anon-profitresearchorganizationthattracksprogressongovernments’pledgesandactionstoaddressclimatechange,theglobalengagementsincetheCOP26havebeenweakened,especiallyinthewakeoftheRussia-Ukraineconflict.Progresshasstalledonmoreambitious2030climatetargets.ThiswasalsoevidentfromrecentCOP27wherestrongerglobalclimateambitionsrelativetoCOP26werelargelyabsent.Andwithoutincreasedpolicyresponse,theworldcouldemitsignificantlymoreGHGs,potentiallyincreasingtheearth’stemperaturetowellabovethe2°Cupperlimitforglobalwarming—withthegoalof1.5°C—establishedbytheParisAgreement.Infact,globalnon-renewable-energy-andfossil-fuel-relatedCO2emiss

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Delays in Climate Transition Can Increase Financial Tail Risks: A Global Lesson from a Study in Mexico

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